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Posted by Lexington Green on November 6th, 2011 (All posts by Lexington Green)

To fix the banking sector, should we rely more on government regulation and oversight or let the market figure it out? Tougher rules or more capitalism? Right now, we have the worst of both worlds. We have a purportedly capitalistic system with a lot of rules that are not strictly enforced, and when things go wrong, the government steps in to protect banks from the market consequences of their own worst decisions. To me, that’s not capitalism.

This is an excellent article. Do please RTWT. It is fascinating how much severe market failure occurs in supposedly providing the truth about banks, or any other company with traded shares. People who know the truth, or can find it out, have stronger incentives to protect their access to clients than to publishing the truth. Happy talk to that great big chump, the public, sells. Incentives are everything, and they lead to globally optimum outcomes only under specific circumstances.

This entry was posted on Sunday, November 6th, 2011 at 5:50 pm and is filed under Economics & Finance, Quotations.
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7 Responses to “Quote of the Day”

Financial regulation should take a page out of Stalin’s book: don’t just balkanize the industry, caucasianize it. Stalin, native to the Caucasus himself, sliced up the political boundaries in the Caucasus so thoroughly that the locals, already prone to feuds, became even more prone to feuds, leaving Moscow the only arbiter.

This was the traditional approach taken to banking regulation in this country from Jefferson to Wall Street BFF William Jefferson Clinton. Finance was sliced up up by state and, following the Glass-Steagal approach, sliced up by line of business. Such slicing reduced those empires to feuding fiefdoms instead of a consolidated lobby, meaning that they were regulated by private turf battles rather than bank regulators whose purchase price was kept artificially low by price controls.

Caucasianizing regulation in the current environment would take the org chart of a large consolidated financial service provider and carve it in such a way that the natural tensions between its competing branches were magnified and turned into a check and balance on the power of the financial services lobby. The creative possibilities of feuding industry blocks was shown in the recent fracas between Big Retail and Big Finance over debit card fees.

The organization forms and incentive structures of large financial companies should be so constituted that, if the firm fails, senior management and ownership are ruined. Before Lehman Brothers and other investment banks became publicly traded firms, they were limited partnerships. If deals and trades were not closely supervised by senior partners, a bad trade by a young renegade trader would have wiped out everyone. Equity dilution in large publicly traded corporations has a pernicious effect because it divorces ownership from responsibility. It’s doubly pernicious with large financial institutions who have other people’s money (OPM) to play with. OPM is a de factor get out of trouble free private subsidy that’s only somewhat less likely to create moral hazard than the get out of trouble free public subsidy that Helicopter Ben gives them.

Bank regulation and government guarantees suppress the market in information about banks.

Detailed government regulation gives the desired impression that government is closely watching the banks. The government’s self assigned role is to prevent banks from failing. This makes government the partner of the banks, perversely and contrary to investor interests. Regulators are against any release of bad information about banks, until they are unable to contain the bad news.

The government guarantees almost all depositors against loss. This makes reckless bank behavior less important politically, and removes most demand for detailed bank financial information. Banks don’t have to be transparent to gain customers, and banks can invest deposits without revealing the details. The government sees bad news about banks as increasing the probability that it will have to pay out its guarantees.

I’m sorry, but this talk about banking regulation as if it’s deep magic from the dawn of time is just pure bulls**t.

Our current banking system is the result of over 100 years of deliberate and persistent political effort to socialize risks while leaving rewards in private hands. (Actually the effort, as opposed to the actuality, is significantly older than that, but that’s another discussion.)

Using the words “market failure” to describe a system that exists precisely to prevent market forces from working is just dumb. Yes, many people have a monetary incentive to ignore, deny, or apologize for that system, and many innocent — or at least naive — people get burned in the process. That’s kind of the whole point.

Here’s a crazy idea: find anyone who accurately called the dot-com, mortgage, and financial bubbles years in advance, and who has been talking about the higher ed bubble for some years now. Ask them what they think.

They will unanimously tell you something pretty close to this:

Banking as it existed in the U.S. for much of the 19th century resembled the Caucusized system that Joseph Fouche describes. No Stalinism required, thank you very much; rather, Andrew Jackson gets much of the credit.

Going back to something resembling that non-system would fix 80 or 90 percent of the problem. Any further regulation would mostly take the form of requiring transparency. Sunlight is the best disinfectant.

When parties collude to deny the public relevant information about potential purchases, that is an example of market failure. You can’t get good market based outcomes where pertinent information is systematically withheld or misrepresented. That is what the article describes, intentional falsification of information available to the public due to collusion.

In the sense I’m speaking of, which I believe is the most common usage, market failure is a misallocation of goods that persists despite the operation of a free market. No market, no market failure.

you are quite right that financial advisers and institutions collude to hide important information from their customers. Such collusion is consistently possible and profitable because financial services in the U.S. are provided at the discretion of a government-managed sector of the economy which shields both individual companies and the industry as a whole from the near term consequences of their actions, in the name of “protecting” investors.

The situation is similar to the way cars and appliances were manufactured behind the iron curtain. The grossly inferior quality of these goods was legendary, but people paid their hard earned money for them anyway because they had precisely two options: own a lousy car or own no car.

In the U.S., most investors have the same two choices: invest via a brokerage industry that lies to its customers with impunity, or don’t invest. Other options are prohibited by law. You only need to look as far as the Intrade banner on the left of this page to see an example.

I feel for anyone who ends up owning the portfolio equivalent of a Trabant, but when you blame that situation on market failure, I can only respond, “You keep using that word. I do not think it means what you think it means.”